In a recently settled enforcement matter, the SEC imposed a $1 million penalty on an investment adviser based on findings that the adviser violated the Investment Advisers Act of 1940 (the “Advisers Act”) and caused violations of the Investment Company Act of 1940 (the “Investment Company Act”). The charges stemmed from inappropriate cross trading and the adviser’s failure to: (i) disclose the resulting favorable treatment of certain advisory clients; (ii) seek to obtain the best price and execution for certain of its clients; and (iii) have in place an adequate compliance program.

A former portfolio manager was found to have caused certain of the adviser’s violations of the anti-fraud provisions of the Advisers Act, and caused violations by the adviser’s clients of Section 17 of the Investment Company Act.

At issue were transactions in non-agency residential mortgage-backed securities (RMBSs) that the portfolio manager believed were desirable investments. The SEC found that when registered investment companies (RICs) managed by the adviser sold positions in RMBS, the portfolio manager sold such securities to a particular broker-dealer and prearranged with the broker-dealer to repurchase them at a small mark-up on the next business day. The sell side of each trade was executed at the highest or only bid received. The SEC found that by cross trading RMBSs at the highest bid, rather than at an average between the highest and lowest current independent bid, the portfolio manager caused the adviser to favor the buyers in the transactions over the sellers, even though the adviser owed the same fiduciary duty to accounts on both sides of the transactions.

Sections 17(a)(1) and 17(a)(2) of the Investment Company Act generally prohibit cross trades between a RIC and any affiliate (or second-tier affiliate) of the RIC, acting as principal, unless the RIC has obtained an SEC exemptive order. Rule 17a-7 under the Investment Company Act exempts from this general prohibition cross trades where the affiliation between a RIC and its counterparty arises solely because the two have a common investment adviser, directors, or officers.

As the SEC Order explains, however, in order to rely on Rule 17a-7, cross trades must be executed at the “independent current market price,” which is defined in relevant part as “the average of the highest current independent bid and lowest current independent offer, determined on the basis of reasonable inquiry.” Cross trades that involve the payment of a brokerage commission, fee, or other remuneration are not eligible to rely on the exemption under Rule 17a‑7. The SEC reiterated its long-standing position that “interpositioning a dealer in cross trades does not remove the cross trades from the prohibitions of Section 17(a),” and emphasized that, “to extent these transactions are effected at the ‘bid’ or ‘asked’ price rather than at an average of the two prices, they would not be in compliance with [Rule 17a-7’s] pricing requirements.”

According to the SEC, the adviser had adopted compliance policies and procedures designed to ensure that any cross trades involving RICs and other accounts managed by the adviser were executed in a manner consistent with Rule 17a-7, but failed to effectively implement those policies. In particular, such policies provided that traders could not purchase a fixed-income security for one account from the broker-dealer to which it has been sold from another account, unless the trade was not pre-arranged and the broker had “assumed risk of ownership of the security,” which was generally defined as “the broker holding the security overnight.” The adviser’s policies also required its traders to execute trades in a manner consistent with clients’ best interests and to employ a trading process “that seeks to maximize the value of a client’s portfolio within the client’s stated investment objectives and constraints.” Traders were required to consider “best prices and consistent liquidity” when executing trades.

Notwithstanding the adviser’s policies, the portfolio manager was able to execute cross trades over the course of more than four years without complying with the adviser’s stated policies. The SEC found that the adviser’s compliance monitoring efforts were insufficient, and that compliance personnel did not adequately follow up on certain matters that could, in retrospect, have been red flags.

The adviser was assessed a $1 million civil money penalty and, having voluntarily placed $1,095,006.10 in escrow to compensate harmed clients, was not ordered to pay any disgorgement. The portfolio manager was assessed a $50,000 civil money penalty and suspended from association with an investment adviser, broker-dealer, or other market participants for nine months. The matter was settled without the respondents admitting or denying the findings.

Our Take

As we have noted in prior client communications, advisers that have the discretion to choose broker-dealers to execute transactions for their client accounts have an obligation to seek best execution. The SEC staff recently published a risk alert regarding key best execution compliance deficiencies identified in its examination program (see our related release here). This matter reflects several of the concerns the SEC highlighted in that alert.

Importantly, this action should remind compliance professionals that there is an obligation not only to adopt compliance policies and procedures that are reasonably designed to ensure that an adviser and its supervised persons do not violate relevant securities laws and associated regulations, but also to implement such policies and procedures. It seems clear from this action that implementation includes ongoing monitoring of compliance policies and procedures to ensure that they are working (and if they are not, to update those policies).

The $1 million penalty underscores the SEC’s apparent intent to impose significant fines on advisers even where no intentional misconduct is alleged. Here, the SEC noted the adviser’s significant cooperation and remedial efforts, including terminating the portfolio manager, hiring a compliance consultant, retaining outside counsel to conduct an internal investigation, placing assets in escrow to compensate harmed investors, and ultimately self-reporting the violations to the SEC staff. In light of the significant penalty, advisers that find themselves in a situation where self-reporting might be warranted should ensure that they have a candid and complete discussion of the pros and cons of self-reporting with competent counsel, executive management, and board members before making that decision.